CorporateDIrect FullLogoWhiteLetter

800-600-1760

CorporateDirect Articles and Resources

Texas: The New Hotbed For Business?

Texas: The New Hotbed For Business?

By: Ted Sutton, Esq.

 

In the business realm, Texas has become the lone star that is burning brighter. And it may become a top state for business in the near future.

 

They say that everything’s larger in Texas. This also includes a larger demand to form a business in the Lone Star State. Forming a business in Texas has become a popular alternative to other larger states like California and New York. Given its thriving economy and a favorable tax climate, Texas has seen an increase in new LLC formations.

 

These formations may increase further. Under the recently-passed Senate Bill 2314, Texas now recognizes the charging order as the exclusive remedy for both single-member and multi-member LLCs.

 

The charging order apples when an LLC member is personally sued and loses in court. But in order for the lawsuit winner to collect anything from the LLC, they must wait until any distributions are made from it. So, if no distributions are made, then the winner doesn’t collect anything from the LLC. This is true, even if the loser is the only member of the LLC. This new law takes effect on September 1, 2023.

 

This new law overrules Devoll v. Demonbreaun, a 2016 Texas Court of Appeals case[1]. Devoll held that the charging order was not the exclusive remedy, even if it was charged against an LLC’s membership interest. This new Senate Bill changes this outcome. Now Texas LLC owners are better protected in the event they are personally sued.

 

On top of this, Texas has also just formed the Texas Business Court. Similar to the Delaware Court of Chancery, this new court system will handle corporate disputes and complex litigation matters. Texas will eventually set up these courts in Austin, Dallas, Fort Worth, Houston, and San Antonio. This court will help expedite lawsuits and provide case law to resolve these disputes. But most importantly, this will attract even more business to the state. These new courts are set to start on September 1, 2024.

 

Another thing Texas has is its large population and rapid population growth. Currently, Texas is the second largest state with 30 million people. And since 2010, Texas has had the third-fastest growth of any state at a whopping 20%. Given these recent trends, it could take that top spot in the not-too-distant future.

 

Could Texas overtake Delaware and Wyoming as the best state for businesses? Only time will tell. However, these recent developments show that it may be possible.

_______________________________

[1] Devoll v. Demonbreun, No. 04-14-00331-CV (Tex. App. Aug. 31, 2016).

 

 

Corporate Direct has a weekly YouTube segment called Direct Answers from Corporate Direct

In this segment, we educate people on corporate law, business formation, real estate, wealth building, and asset protection. And if you have any general questions about something, please feel free to leave a comment on one of our videos!

For more of these updates, click the link below and subscribe to our YouTube channel.

Five Reasons Why We Don’t Recommend DAO LLCs

We Don't Recommend DAO LLCs

By: Ted Sutton, Esq.

Over the last few years, the use of blockchain technology has exploded onto the scene. DAOs have grown in popularity alongside it.

So, what exactly is a DAO? A DAO is a new entity form that stands for Decentralized Autonomous Organization. What’s unique about them is how they can be managed. Like other entities, individual members can manage DAOs. What makes them different is that they can also be managed by a smart contract on the blockchain ledger. This new and unique form of management has encouraged people to form them as partnerships, which offer no protection. Because of this, a better vehicle was needed.

In response to this demand, some states have already enacted new laws. Wyoming has passed legislation allowing for DAOs to be formed as “DAO LLCs.” Tennessee has passed a similar law allowing for Decentralized Organizations, or “DO’s.” These entities can be formed with the Secretary of State and provide the same asset protection as LLCs. Utah also passed a similar act that allows for the creation of “limited liability decentralized autonomous organizations,” or “LLDs” for short.

Proponents say that this smart contract management makes the DAO easier to be managed remotely, more efficient to govern, and removes any management conflicts between humans. While these things may be true, there are five reasons why we here at Corporate Direct do not recommend forming DAOs for our clients.

    1. The Smart Contract is open-sourced

The first reason is that the smart contract is available for public view. Because the smart contract is on the blockchain ledger, anyone can see how your DAO is being managed. On top of this, the Wyoming Secretary of State requires DAO applicants to include the smart contract’s public identifier when forming the DAO LLC. So anyone can see your LLC’s roadmap. Do you want the world knowing how you distribute profits? Unlike a DAO’s smart contract, an LLC’s operating agreement or a Corporation’s bylaws are not available for public view. Every other entity provides this type of privacy. DAOs do not, which is why we stay away from them.

    1. The DAOs can still be hacked

Second, DAOs can still be hacked, even with a smart contract in place. This happened in the California case of Sarcuni v. bZx DAO. In Sarcuni, people deposited digital tokens into the bZx DAO in exchange for membership interests. Over time, the DAO accumulated over $50 million worth of these tokens.

One day, one of the members received a phishing email from a hacker. After the member opened the email, the hacker was able to access the member’s private key and take $55 million worth of funds from the DAO. One would think that the DAO’s smart contract would have stopped this transfer. But that was not the case. In fact, the DAO had lost $9 million in three previous hacks.

On top of this, the court also found that because the DAO is not a recognized entity type under California law, DAO’s are treated as general partnerships. This means that if the DAO is sued, each of its members are personally on the hook for any liability. Was anyone sued personally for the loss of $64 million in the Sarcuni case? Under California law, they could be.

Given the recent rise in computer scams, any business can be a victim to them. But because DAOs with smart contracts face these same risks, they are a much less appealing option. Even worse, if your state doesn’t recognize DAOs, any member is individually liable for any claims brought after the DAO has been hacked.

    1. The law still applies to DAOs and their owners

We also don’t recommend the DAO since they may still be subject to other regulatory requirements, even when its owners try to avoid them. This happened in the case of Commodity Futures Trading Commission v. Ooki DAO. In Ooki, BZero X LLC operated a trading platform where people would exchange virtual currencies on the blockchain network. In an attempt to avoid regulatory oversight from the CFTC, BZeroX transferred their protocol into the Ooki DAO. After this move, the CFTC filed suit against Ooki.

The court found that because the DAO traded commodities, the DAO was subject to regulation under the Commodity Exchange Act (CEA). On top of this, the court found that under the CEA, DAOs are treated as unincorporated associations. Like general partnerships, this also means that Ooki’s members are subject to personal liability.

While people may think that they can use DAOs as a conduit to avoid the law, they are sorely mistaken. You are much better off using a traditional LLC.

    1. DAO owners can be personally liable if the DAO is sued

In states that do not have DAO legislation on the books, DAO owners can be personally liable if the DAO gets sued.

The Sarcuni court found that DAOs are treated like general partnerships. In addition, the Ooki court found that DAOs are treated like unincorporated associations under California and Federal law. In both of these cases, after the DAO was sued, all of its owners were personally liable for any judgment entered against each DAO.

From a liability standpoint, this is disastrous for every DAO member. However, members of properly formed LLCs and Corporations do not have to face this issue. If those entities are sued, their owner’s liability is limited to their capital contributions. Not so in states that don’t recognize the DAO as its own entity.

    1. There is too much legal uncertainty with DAOs

The fifth and final reason for DAO avoidance is that there is too much legal uncertainty associated with them. Only three states have DAO laws on the books. Because of this, there are neither enough regulations nor enough case law to regard DAOs as a safe entity to recommend to our clients.

There are simply too many unknowns at this point in time. And we don’t want our clients to be the test cases.

Conclusion

There is a chance that some of these things may change in the future. Additional states could pass legislation that treat DAOs like LLCs with their own liability protections. Smart contracts could do a better job of stopping hackers. Lawmakers and agencies may also enact clearer regulations regarding DAOs. But because people face these issues when forming DAOs now, we do not recommend them for our clients.

Corporate Direct has a weekly YouTube segment called Direct Answers from Corporate Direct

In this segment, we educate people on corporate law, business formation, real estate, wealth building, and asset protection. And if you have any general questions about something, please feel free to leave a comment on one of our videos!

For more of these updates, click the link below and subscribe to our YouTube channel.

AI May Be Infringing On Your Copyrights

artificial intelligence 7450797 1280

By: Ted Sutton, Esq.

Intro

Many people have used AI to generate new artworks. A few of them can generate an image. And as we saw with the artificial hit “Heart on My Sleeve” meant to sound like Drake and The Weeknd, AI can also generate new songs.  But if you make these new works, you could face liability.

AI stands for artificial intelligence. This intelligence simulates that of humans, as it teaches machines to learn, perform tasks, and make decisions. Hot new search engines such as ChatGPT and Google Bard are forms of AI.

Other AI programs such as Midjourney and Stable Diffusion generate paintings. Users can input text describing the painting they want, and the programs will generate a painting for them. While you may love the final painting, you may hate the fact that you could be sued for copyright infringement.

What is a Copyright?

A copyright is any expressive work of art made by someone. These works can include books, movies, songs, paintings, and even sculptures. People who make these works can register them with the Copyright Office to obtain copyright protection.

What is Copyright Infringement?

A person can infringe on another’s copyright if they either reproduce the work, or make a similar work without the copyright owner’s permission. With people, infringement is more straightforward. But when AI infringes on others copyrights, the issue is much more complicated.

AI can infringe on other’s copyrights in two ways.

AI Training Process

The first way AI can infringe on copyrights is through its training process. All new forms of AI are trained to create new expressive works that could be copyrightable. But in order to train the AI to do this, its programmers need to show it large amounts of data from the internet. Some of this data, however, is copyrighted.

AI Outputs

The second way AI can infringe on copyrights is by the output. When a user enters text into an AI program, the output, or the final product, may be very similar to an already copyrighted work.

Is it Infringement?

Under current US case law, a copyright holder can show copyright infringement by proving two things:

  1. That the infringer has access to the copyrighted work; and
  2. That the infringer’s work was “substantially similar” to the copyrighted work.

Let’s use “Heart on My Sleeve” as an example here. Before generating the song, the AI that made it certainly had access to copyrighted works by both Drake and the Weeknd. How else would the voices in the song sound exactly like them?

Also, while you could make the argument that “Heart on My Sleeve” was a different song, it’s still obvious that it sounds “substantially similar” to anything Drake or The Weeknd produces.

Because of this, either the AI user or the AI company could be liable for copyright infringement.

Does the AI have a defense?

One defense that AI companies can assert is the fair use defense to copyright infringement. If an infringer copies the copyrighted work and uses it as a “fair use,” that infringer will be protected. Fair use of a copyrighted work can include criticisms, commentary, satire, news reporting, and teaching.

But does using copyrighted work in the AI training process, or creating an output that is similar to a copyrighted work, constitute a fair use?

Courts look at 4 factors to determine if a use is fair:

  1. The purpose and character of the use, including whether the use is of a commercial nature or is for nonprofit educational purposes;
  2. The nature of the copyrighted work;
  3. The amount and substantiality of the portion used in relation to the copyrighted work as a whole; and
  4. The effect of the use upon the potential market for or value of the copyrighted work

We’ll use “Heart on My Sleeve” again.

For the first factor, if the use is more commercial in nature, it will likely not be fair use. It is highly unlikely that the use would be for educational purposes. Plus, the person who posted the song made several thousand dollars after its release. So, under the first factor, “Heart on My Sleeve” is likely not a fair use.

For the second factor, if the nature of the copyrighted work was creative or imaginative, then the infringing work is likely not a fair use. Clearly, because Drake and the Weeknd’s are world famous artists, their copyrighted works are creative. Because of this, “Heart on My Sleeve” is likely not a fair use under the second factor.

The third factor, however, isn’t as clear. An AI company could argue that because the AI looked at many different songs, “Heart on My Sleeve” took a small and insubstantial amount from Drake and the Weeknd’s copyrighted works. Because of this, the third factor could constitute fair use.

The fourth factor focuses on the economic effect of the infringing work. If the infringing work would cause economic harm to Drake and the Weeknd, then the work likely would not be a fair use. As described before, “Heart on My Sleeve” made thousands of dollars. That is money that could have gone to Drake and the Weeknd. Because of this, “Heart on My Sleeve” is likely not fair use under the fourth factor.

Drake and The Weeknd could claim that the AI-generated “Heart on My Sleeve” is not fair use. However, a court could rule either way under this untested area of copyright law.

Who owns the Copyright?

Another question is if a copyright owner sues for copyright infringement, who is the rightful owner of the copyright?

Copyright owners are usually the “authors” of the copyrighted work. But when a user generates a work by using AI, it is unclear who the true “author” of the copyrighted work is. Is it the person who entered the text? Or is it the AI software that was both trained to and actually generated the image?

Another question to ask: who should you sue for copyright infringement? The AI company, or the person who used the AI?

Also, would it be fair to hold the user liable? They didn’t know what the final product would look like. And they certainly didn’t train the AI by using other people’s copyrights.

Lawsuits

Some people have already filed lawsuits against AI companies. Getty Images has already filed a lawsuit against Stable Diffusion. Getty alleges that Stable Diffusion improperly used their photos to train its AI, in violation of the copyrights that Getty holds.

Individuals have also filed suit against these AI companies. Last year, a group of artists sued several AI companies. They allege that the AI companies both improperly used their photos to train the AI, and that the AI’s outputted photos are substantially similar to their own works.

Because AI brings a new set of untested issues to copyright law, it is unclear who the court would rule for.

Solutions

As of right now, there are far more questions than there are answers. But in order to have these much-needed answers, we will need several things to happen.

First and foremost, Congress needs to act as soon as possible. They need to determine who owns the copyright to AI-generated works, who authored the work, and when exactly does an AI-generated work infringe on another’s copyrighted work? If they don’t, then there’s a good chance that innocent people who use the AI could be sued for copyright infringement.

To protect themselves from these lawsuits, AI users will need to demand more from the AI companies. Before using their services, companies should inform users that they have permission to both use copyrighted works in their training data and the outputted result. This will ensure that innocent users will not be sued by copyright owners.

But before they can do this, AI companies will need to get permission from the copyright holders themselves. These companies will not only need to obtain the consent of copyright owners, they will also need to compensate them. It is only fair for copyright owners to receive a payment if they agree to have the AI use their works.

Copyright holders should also do their due diligence. They should be on the lookout to see if AI companies are using their works. If they do, they should demand compensation.

Lastly, insurance companies and third-party vendors should demand from AI companies that they are licensed to use others works. This will help protect all parties from liability if a copyright infringement suit is brought.

Conclusion

AI is changing the world at a rapid pace. Some of that change may be welcomed. However, this changed is certainly not welcomed by copyright owners. We need to act fast to address these issues. If not, innocent people could be liable through no fault of their own.

 

Resources

 

Commingling Funds – Why you should NEVER do it

Commingling Funds Why you should NEVER do it

    By Ted Sutton, Esq.

Ryan was always ambitious and hard working. As a teen, he would regularly work on house flips with his dad. But when Ryan turned 18, he decided to start his own house flipping business.

 

After listening to his dad’s advice, Ryan formed an LLC for his house flipping business. A service helped him form an LLC with the Secretary of State, provide a registered agent address, and draft an operating agreement for his business. Once he began flipping houses, Ryan held himself out as the manager of the LLC.

 

But he skipped the step of forming a separate bank account. His dad never used one, so he didn’t feel the need to set one up. Any business funds were deposited and paid out from Ryan’s personal bank account. This was the same account Ryan used to pay his rent and other personal expenses.

 

After Ryan had been flipping homes for one year, one of his home buyers tripped and fell on a broken staircase. The buyer then filed suit against the LLC. After a lengthy trial, the court found that the LLC was liable for the buyer’s injuries. But because the LLC did not have a separate bank account, the buyer was able to reach Ryan’s personal bank account.

 

Because Ryan commingled business and personal funds, he was personally on the hook. He could not use the corporate veil to shield himself from personal liability.

 

What is Commingling Funds?

 

When you form a business, you can NEVER commingle funds. But what exactly does it mean to commingle funds?

 

A person commingles funds when they mix business and personal funds into a single bank account. But if you do this as a business owner, you can run into a lot of trouble.

 

When someone sues your business, a plaintiff may try to pierce the corporate veil to hold you personally liable. The corporate veil itself symbolizes that you are keeping your business property separate from your personal property.

 

But if you follow the list of corporate formalities, you can stop someone from piercing the corporate veil. The list varies by state, but it may include the following:

 

    1. Properly formed under the Secretary of State
    2. Maintaining separate bank accounts
    3. Maintaining separate records
    4. Having an operating agreement or bylaws
    5. Having bank accounts that are adequately capitalized
    6. Holding company out as a separate business
    7. Holding yourself out as manager of that business
    8. Conducting regular meetings
    9. Having minutes of those meetings
    10. Following other rules and regulations
    11. Legal entity separate from its owners
    12. No commingling of funds
    13. No personal obligations from business bank account
    14. No evidence of fraud or injustice
    15. Maintain annual filings, annual report, fees, good standing
    16. Having a registered agent
    17. Paying taxes for corporation
    18. Filing separate tax returns
    19. Making proper distributions
    20. Selling interests with proper approval
    21. Issuance of stock or membership certificates

 

If you follow most of these formalities, there will be a sufficient separation between you and your business. If this separation exists, you will not be held personally liable. But if there is no separation, then you are individually on the hook for any judgment entered against you. For more information on the corporate formalities, please check out my dad’s most recent book, Veil Not Fail.

 

In many states, the first formality that courts look at in veil piercing cases is whether the business owner commingled personal and business assets. You do not want this to work against you. If you don’t follow this first formality, it is very easy for the court to pierce the veil. But if you form a separate bank account that keeps your business assets separate from your personal ones, the veil will be much more difficult to pierce.

 

After you get an EIN number from the IRS, opening a business bank account at the beginning is very easy. In fact, many banks have low minimum balance requirements for business bank accounts. Having this separate account will protect you in the long run because it may shield you from personal liability.

 

Is it commingling or not?

 

It is also worth mentioning what constitutes commingling funds and what does not. Knowing these differences will help you properly operate your business.

 

One thing that does not constitute commingling is having bank statements mailed to your personal residence or a P.O. Box. This is especially true if your business is a passive holding company. If your business does not have a physical address, your personal residence may be the only address where banks can send bank statements. Another thing that does not constitute commingling is using your business bank account for all business income and expenses.

 

However, there are some things that do constitute commingling. Clearly, one of them is using one bank account for both business and personal expenses. Another is using your business bank account for any personal expenses, and vice versa. But if you keep these things separate, you will not be commingling funds.

 

Is Commingling
Is Not Commingling
- Using one bank account for business and personal expenses
- Sending bank statements to your - personal residence
- Loaning business funds to business owners for personal expenses
- Sending bank statements to a P.O. Box
- Using business funds to cover personal obligations
- Depositing business income into your business bank account
- Using personal funds to cover business obligations
- Paying business expenses from your business bank account
- Paying personal expenses from your personal bank account

Conclusion

 

Had Ryan set up a separate business bank account at the start, he would have stopped the buyer from piercing the corporate veil. After all, he followed many of the other corporate formalities. But because he didn’t have a business bank account, he was personally liable to the buyer.

 

Do not make the same mistake Ryan made. Have two separate bank accounts and use them as such.

The Q-Sub

By: Ted Sutton

What a Q-Sub is and How It Can Help Your Business

Diane has been obsessed with dogs from a very young age. She was very close with her childhood hound, and enjoyed spending time with other dogs she knew. After the hound’s passing, she vowed to make a career out of tending to our four-legged friends. She kept her word into adulthood. After graduating high school, she set up a dog store in town. Like a responsible business owner, she properly formed an LLC taxed as an S-Corp for the store.

After setting up shop, Diane soon discovered that there were very few dog grooming services in town. Given this business opportunity and her passion for dogs, Diane decided to capitalize. A few weeks later, she set up a dog grooming service in the dog store.

Over time, Diane began establishing a rapport with her clients. She noticed that many of them dropped off their dog for grooming before work and picked them up after the work day ended. What were the dogs to do after they had been groomed? Because the dogs spent all that time with her, Diane decided to provide a dog walking service.

Now Diane is in charge of three separate businesses operating under the same LLC. She has employees who work for all three and has separate obligations for each. Diane has a lot on her plate. She begins to worry about the direction of her businesses. What will she do with employee payroll? What if someone slips in the dog store? What happens if a dog bites someone while on a walk?

To address these fears, the IRS has a solution. Diane can set up Q-Subs for each of her businesses.

What are Q-Subs?

A Qualified Subchapter S Subsidiary (Q-Sub) is an S-Corp that is 100% owned by a parent S-Corp. Both the parent entity and the Q-Sub can be a corporation or an LLC. Parent S-Corps can own more than one Q-Sub, but they must make the election for each Q-Sub by filling out Form 8869 on the IRS website. This election must also be timely filed. If it is not, the Q-Sub will be taxed as a C-Corp.

Because the parent S-Corp files the tax return, the Q-Sub is not treated as a separate entity for tax purposes. However, Q-Subs are still responsible for a few things. Q-Subs must still obtain an EIN number from the IRS. Q-Subs are also separately responsible for some taxes, including employment taxes, some excise taxes, and certain other federal taxes. They should also follow all the corporate formalities (i.e. annual minutes) of a separate entity.

How they can help your business

There are a wide range of benefits that Q-Subs offer for business owners.

Q-Subs aid business owners when their S-Corp has more than one business activity. The S-Corp can limit its liability by separating its different business activities into different Q-Subs. Having this structure is certainly advantageous from an asset protection standpoint. Here, Diane only has one LLC set up for her dog store, dog grooming business, and dog walking business. Because Diane is concerned about liability, she sets up two separate Q-Subs for the dog grooming and dog walking businesses. In the event a dog bites someone on a walk, that person can only reach the assets inside the Q-Sub set up for the dog walking business. This business structure is diagrammed below:

qsub graph 1

Q-Subs come in handy when there are state and local transfer taxes that apply to sold property. In some states, transferring the property to a Q-Sub in exchange for 100% of the Q-Sub’s stock can avoid these types of transfer taxes. Let’s say that Diane lives in a state that allows these transfers without incurring tax. After setting up the Q-Sub for the dog grooming business, she wants to transfer title to the dog grooming tables into the new entity. If this transfer involves the dog store owning 100% of the dog grooming company’s stock, Diane will not have to pay any transfer taxes.

The IRS provides business owners with incentives when forming a Q-Sub. An S-Corp can deduct up to $5,000 in organizational costs the first year the Q-Sub is formed. After setting up the new dog grooming and dog walking businesses, Diane incurs $17,000 in such costs during the first year. Because the IRS offers these deductions, she can deduct $10,000 in organizational costs between the two new businesses, and deduct the remaining $7,000 in later years.

Businesses with two or more related entities use Q-Subs to minimize employee payroll taxes. When employees work for two related corporations, one corporation can set up a Q-Sub to employ the employee to avoid any double tax. Diane employs people who assist with the dog store, dog grooming, and dog walking. Instead of placing them on the payroll of all three entities, Diane sets up a third Q-Sub to employ everyone who helps with all three. This will prevent Diane from overpaying on payroll taxes. This business structure is diagrammed below:

qsub graph 2

Instead of filing separate tax returns for each entity, the parent S-Corp only needs to file one tax return for itself and its Q-Subs. At this point in time, Diane owns the dog store, dog grooming business, dog walking business, and a Q-Sub that employs everyone. With four entities, Diane thinks that tax season will be a nightmare. Fortunately, only the dog store will need to file a tax return on behalf of all four businesses. This certainly makes life easier for everyone during tax season.

Q-Sub elections are useful when S-Corps are bought and sold. If one S-Corp buys a second S-Corp, the first S-Corp could elect to treat the second as a Q-Sub.

Jack is a well-known figure and has the only doggy daycare in town. Many of the clients who buy products at Diane’s dog store give their dogs to Jack when they take a trip. At this point in time, Jack has run the daycare for over 30 years. While he also shares a passion for dogs, he decides that it is time to move on and calls it quits.

Diane views this as a perfect opportunity to add to her growing repertoire of dog businesses. Diane approaches Jack with an offer to buy the daycare. Jack is excited by this proposal. He can cash out, retire, and buy that coveted house in Hawaii to spend the rest of his days with his wife.

Both agree to the arrangement. After consultations from competent accountants and attorneys, Diane uses the dog store to buy the doggy daycare. The dog store now owns four Q-Subs, but both parties are happy. Diane has a near monopoly on dog products in town, and Jack can finally retire to Hawaii. This business structure is diagrammed below:

qsub graph 3

Lenders may want to create more lending protection by requiring S-Corp borrowers to hold loan collateral in a Q-Sub. After buying the doggy daycare from Jack, Diane realizes that she needs more kennels to house the growing number of dogs staying overnight. This will not be a cheap purchase.

Diane decides to buy the kennels on credit and approaches the bank seeking a loan. After reviewing her business credit, the bank tells Diane that they will need the kennels to be held as collateral in a Q-Sub. Fortunately, the doggy daycare business is already a Q-Sub. Both parties agree to the arrangement, and the kennels are held in the doggy daycare business as planned.

Given the numerous benefits that Q-Subs provide, business owners should consider forming them in the right circumstances. They helped Diane. And if you are faced with similar issues, they can certainly help you.

Employer Identification Number (EIN)

EIN stands for Employer Identification Number. The IRS requires that you have such a number when you incorporate or form an LLC. Think of an EIN as a Social Security number for your business. You will file all your tax returns using this number and you will need this number to open a bank account for the business.

Once you’ve filed your incorporation papers and they’ve been approved by the Secretary of State, your corporation needs to file for an Employer Identification Number, or EIN. An EIN is a permanent number assigned to your business, which is used for official corporate business such as opening bank accounts and paying taxes.

How Do I Get an EIN?

You can apply for the EIN yourself on the IRS.gov website for free; however, some people find this confusing and/or do not wish to spend the time doing it themselves. If this is the case for you, Corporate Direct can obtain one for you for a small service fee. Whichever way you choose, know that it required for your business.

The IRS allows businesses to apply for an EIN either online, by phone, fax or mail. If applying online, the EIN is assigned immediately upon completion of the interview-style application that walks you through type of business, identity of business, authentication, addresses, details and confirmation of the new EIN number.

Even though receiving the number is immediate, it can take up to two weeks to be added into the IRS database and until it is added, the number can’t be used for filing returns. In order to avoid any issues, be sure to obtain your EIN as soon as possible.

C Corporation

What is a C Corporation?

illustration of a storefrontCorporations have been used for over 500 years to limit owners’ liability and thus encourage business investment and risk taking. Their use for this purpose continues to this day. 

You will hear about both C Corporations and S Corporations. Both are corporations with charters granted by the state of organization. You can organize in Nevada for the best asset protection laws, for example, and qualify to do business in California. In that case, you will have one corporation paying annual fees in two states (which many people do). While we like and often use S Corporations, we keenly appreciate the advantages of C Corporations. They certainly have their merit and a place in your entity structure strategy.

The C and the S refer to IRS Code Sections. C corps feature a double taxation – one tax at the company level and another tax on profits distributed to shareholders. This double tax is why many people consider S corps, which has only one level of tax. But there are restrictions on ownership of S corps, where as there are no such limits on C corps.

Here is a quick list of C Corporation advantages:

  • They can have an unlimited amount of shareholders, from anywhere in the world.
  • For Nevada and Wyoming corporations, officers and directors can reside anywhere in the world. This can be a boon for foreign investors. 
  • They can have several different classes of shares.
  • They have the widest range of deductions and expenses allowed by the IRS (more on this below).
  • They are the most widely recognized business entity in the world, and are the premier entity for going public.
  • In Nevada and Wyoming, nominee (or stand-in) officers and directors can be utilized, adding extra levels of privacy.
Image Link to download full c-corporation guide pdf

Tax Advantage: Wide Range of Deductions and Expenses

A C Corporation has the widest range of deductions and expenses allowed by the IRS, especially in the area of employee fringe benefits. A C Corporation can set up medical reimbursement and other employee benefits, and deduct the costs of running these programs, including all premiums paid. The employees, including you as the owner/shareholder, will also not pay taxes on the value of those benefits.

This is not the case in a flow-through entity, such as an S Corporation, LLC or LP. In each of those cases the entity may write off the costs of the benefits, but any employee/shareholder who owns more than 2% of the entity will pay taxes on the value of their benefits received. So, if having the maximum deductions and all of the employee fringe benefits on a tax-free basis is important to you, a C-Corp may be your entity choice.

Which type of business works well as a C Corp?

C Corporations are great for a business that sells products, has a storefront and employees, and may or may not have a warehouse where it keeps its inventory. C-Corps don’t work well with businesses that want to hold appreciating assets, such as real estate, because of the tax treatment on the sale of these assets.

Tax Disadvantage: Double Taxation Issues

The most often-cited disadvantage of using a C-Corp is the “double-taxation” issue. Double-taxation happens when a C-Corp has a profit left over at the end of the year and wants to distribute it to the shareholders as a dividend. The C-Corp has already paid taxes on that profit, but once it distributes the profit to its shareholders, those shareholders will have to declare the dividends they receive as income on their personal tax returns, and pay taxes again, at their own personal rates.

How to Avoid the Double-Taxation Scenario

There are many things you can do to avoid the double-taxation scenario:

  • Structure the C-Corp so that there are no profits left over – use all of the write-offs and deductions allowed by the IRS to reduce the C-Corp’s net income.
  • Offer great benefit plans!
  • Pay higher salaries to yourself and the other owner/employees than you would if you were using a flow-through entity such as an S-Corp. Yes, you will have to pay payroll taxes and personal income taxes on those monies, but you would pay personal taxes on dividends paid to you anyway. And it may be that in the big picture, the savings on one side outweigh the additional taxes paid on the other side.

The decision as to what entity is best for you really does, in so many cases, hinge on taxes, and that is why, with any corporate-related decision, you are wise to seek the advice and assistance of a good CPA.

Corporate Direct along with your CPA can help you decide which corporation is best for you.

S Corporation

Is an S Corporation the right entity type for you?

This is a great question to explore when starting a business, or changing your existing business from a Sole Proprietor or General Partnership. It can make a difference in asset protection as well as in taxes. An S Corporation is one of the three popular choices for those incorporating their business. Other choices include Limited Liability Companies (LLCs) and C Corporations.

Business owners can select how they wish to be taxed, and an S Corporation is one of those tax designations that can make a big difference in how much you pay in taxes, and how to handle profits and distribute shares. There are pros and cons to every entity type and it’s important to understand which business model is best for you.

An S Corporation is a corporation that has elected to be taxed as a flow-through entity (similar to an LLC or Limited Partnership). The “S” also refers to an IRS code section. This type of taxation, the S election, allows the shareholders to be taxed only at the individual level only instead of at both the corporate and individual level, thus avoiding the double taxation like the C Corporation.

Of all of the entities, the S Corporation has the tightest restrictions on ownership. There can only be 100 or fewer shareholders (owners), which all must be individuals or their living trusts. Corporations, multi-member LLCs, and non-US residents cannot be S Corporation owners. If the restrictions aren’t followed, the IRS will decide the corporation is C Corp and will double tax it accordingly.

S Corporations can help some service-oriented businesses to avoid being characterized as a Personal Service Corporation, or “PSC” by the IRS. PSCs are C Corporations that are classified by the IRS as providing a service, such as consulting, to the general public.

Now, as you may know, the IRS assesses C Corporations with a pretty low initial rate — 15% on earnings up to $50,000. That’s quite a bit lower than you would pay personally if you were receiving that same $50,000 as salary. And, that 15% rate is also lower than you would pay if your business was an S Corporation. So, to head off the anticipated revenue drain, the IRS closed the loophole by designating C Corporations that provide services as PSCs.

The tax rate for PSC earnings? 35%! That’s probably higher than you would pay through your S Corporation if you took a reasonable salary and the rest as passive income. And, it’s enough, in many cases, to make the difference between going “S” or going “C.” Again, you will work with your CPA, tax and/or legal advisors to determine the best entity for your specific situation.

Advantages Of S Corporations:

  • Limited liability for management and shareholders.
  • An unlimited number of management, no state residency requirements.
  • Distinct, court-recognized existence, which helps protect you from personal liability that can cause you to lose your personal wealth in assets like your home, car, or nest egg.
  • Flow-through taxation: Profits are distributed to the shareholders, who are taxed on profits at their personal level.
  • Good privacy protection, especially in Nevada and Wyoming.
  • Great income-splitting potential for owner/employees. Can take a smaller salary and pay income taxes and regular payroll deductions, then take the remainder of profit as a distribution subject to income tax only.
  • S Corporations are great for businesses that:
              • will provide a service (i.e. consultants);
              • will not have significant start-up costs;
              • will not need to make major equipment purchases before beginning operations; and
              • will make a sizable amount of money without a great deal of expense.

Disadvantages Of S Corporations:

  • At shareholder level, shares are subject to seizure and sale in court proceedings.
    Maximum of 100 shareholders, all of whom must be U.S. residents or resident aliens. Shares must be held directly, except in special circumstances.
  • Owner/employees holding 2% or more of the company’s shares cannot receive tax-free benefits.
  • Because flow-through taxes will be paid at the personal rate, high-income shareholders will pay more taxes on their distributions.
  • Not suitable for estate planning vehicle, as control is ultimately in the hands of the stockholders. In a planned gifting scenario, once majority control passes to children from parents, children can take full control of the company.
  • If tax status is compromised by either non-resident stockholder or stock being placed in corporate entity name, the IRS will revoke status, charge back-taxes for 3 years and impose a further 5-year waiting period to regain tax status.
  • Not suitable to hold appreciating investments. Capital gain on sale of assets will incur higher taxes than with other pass-through entities such as LLCs and Limited Partnerships.
  • Limited to one class of stock only.

What is needed to form a corporation? How does it protect me?

Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it — the corporation — is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners’ liability is limited to the monies they used to start the corporation, not all of their other personal assets. In the event of a lawsuit it is the company, not the individuals, being sued.

A corporation is organized by one or more shareholders. Depending upon each state’s law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners’ privacy, nominee officers and directors may be utilized. A corporation’s first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including frequently, the company’s attorney.

The articles of incorporation set out the company’s name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.

Can I change entity types?

Yes, if you think you may want to go public at some point in the future, but want initial losses to flow through, consider starting with an S Corporation or a Limited Liability Company. You can always convert to a C Corporation at a later date, after you have taken advantage of flowing through losses. Corporations can make the election at the beginning of its existence or at the beginning of a new tax year.

More benefits to business owners: No self-employment tax!

The big benefit of S Corporation taxation is that S Corporation shareholders do not have to pay self-employment tax on their share of the business’s profits. But they will be taxed on the salary they pay themselves. This is the catch. Before there can be any profits, each owner who also works as an employee must be paid a “reasonable” amount of compensation (e.g., salary) that is subject to Social Security and Medicare taxes to be paid half by the employee and half by the corporation. As such, the savings from paying no self-employment tax on the profits only kick in once the S Corporation is earning enough that there are still profits to be paid out after paying the mandatory “reasonable compensation.”

More Questions? An Incorporating Specialist can help!

Limited Partnerships – Advantages and Case Study

Advantages of Limited Partnerships

  • LPs allow for pass-through taxation for both the limited partner and the general partner.
  • Limited partners are not held personally responsible for the debts and liabilities of the business, although the GP, if an individual, may be personally responsible.
  • The general partner(s) have full control over all business decisions, which can be useful in family situations where ownership – but not control – has been gifted to children.
  • Estate planning strategies can be achieved with LPs.
  • Limited partners are not responsible for the partnership’s debts beyond the amount of their capital contribution or contribution obligation. So, unless they become actively involved, the limited partners are protected.
  • As a general rule, general partners are personally liable for all partnership debts. But as was mentioned above, there is a way to protect the general partner of a limited partnership. To reduce liability exposure, corporations or LLCs are formed to serve as general partners of the limited partnership. In this way, the liability of the general partner is encapsulated in a limited liability entity.
  • Because by definition limited partners may not participate in management, the general partner maintains complete control. In many cases, the general partner will hold only 2% of the partnership interest but will be able to assert 100% control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted limited partnership interests to his children. Until such family members are old enough or trusted enough to act responsibly, the senior family members may continue to manage the LP even though only a very small general partnership interest is retained.
  • The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.
  • Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner which does not hold a lot of assets.
  • The limited partnership provides a great deal of flexibility. A written partnership agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted partnership agreement.
  • Limited partnerships, like general partnerships, are flow-through tax entities.

For more information on this topic, get the book!

Photo of book

Click here to get it on Amazon

Case Study:

When a Limited Partnership is Best

Jim is the proud father of three boys. Aaron, Bob, and Chris are active, athletic, and creative boys almost ready to embark upon their own careers. The problem was that they were sometimes too active, too athletic, and too creative.

At the time Jim came to see me, Aaron was seventeen years old and every one of the seemingly unlimited hormones he had was shouting for attention. He loved the girls, the girls loved him, and his social life was frenetic and chaotic.

Bob was sixteen years old and sports were all that mattered. He played sports, watched sports, and lived and breathed sports.

Chris was fifteen years old and the lead guitarist in a heavy metal band. When they practiced in Jim’s garage the neighbors did not confuse them with the Beatles.

Jim has five valuable real estate holdings that he wants to go to the boys. His wife had passed on several years before and he needed to make some estate planning decisions. But given the boys’ energy level and lack of direction he did not want them controlling or managing the real estate.

Jim knew that if he left the assets in his own name, when he died the IRS would take 55% of his estate, which was valued at over $10 million. And while estate taxes were supposed to be gradually eliminated, Jim knew that Congress played politics in this arena and no certainty was guaranteed. Jim had worked too hard, and had paid income taxes once already before buying the properties, to let the IRS’s estate taxes take away half his assets. But again, he could not let his boys have any sort of control over the assets. While the government could squander 55% of his assets, he knew that his boys could easily top that with a 100% effort.

I suggested that Jim place the five real estate holdings into five separate limited partnerships.

I further explained to Jim that the beauty of a limited partnership was that all management control was in the hands of the general partner. The limited partners were not allowed to get involved in the business. Their activity was “limited” to being passive owners.

It was explained that the general partner can own as little as 2% of the limited partnership, with the limited partners owning the other 98% of it, and yet the general partner can have 100% control in how the entity was managed. The limited partners, even though they own 98%, cannot be involved. This was a major and unique difference between the limited partnership and the limited liability company or a corporation. If the boys owned 98% of an LLC or a corporation they could vote out their dad, sell the assets, and have a party for the ages. Not so with a limited partnership.

The limited partnership was perfect for Jim. He could not imagine his boys performing any sort of responsible management. At least not then. And at the same time he wanted to get the assets out of his name so he would not pay a huge estate tax. The limited partnership was the best entity for this. The IRS allows discounts when you use a limited partnership for gifting. So instead of annually gifting $14,000 tax free to each boy he could gift $16,000 or more to each boy. Over a period of years, his limited partnership interest in each of the limited partnerships would be reduced and the boys’ interest would be increased. When Jim passes on, his estate tax will be based only on the amount of interest he had left in each limited partnership. If he lives long enough he can gift away his entire interest in all five limited partnerships.

Except for his general partnership interest. By retaining his 2% general partnership interest, Jim can control the entities until the day he dies. While he is hopeful his boys will straighten out, the limited partnership format allows him total control in the event that does not happen.

Jim also liked my advice that each of the five properties be put into five separate limited partnerships. I explained to him that the strategy today is to segregate assets. If someone gets injured at one property and sues, it is better to only have one property exposed. If all five properties were in the same limited partnership, the person suing could go after all five properties to satisfy his claim. By segregating assets into separate entities the person suing can only go after the one property where they were injured.

Jim liked the control and protections afforded by the limited partnership entity and proceeded to form five of them.

Is a Limited Partnership right for you? Get your free 15-minute consultation today!

How to Set Up Single Member LLCs

You must be very careful when you are the only owner of your LLC. Single member LLCs require extra planning and special language in the operating agreement.

One example: What happens when the single owner/member passes? Who takes over? It may be months before that is sorted out, and your business will falter without a clear leader.

Difficulties of Owning a Single Member LLC

You want the asset protection benefits of a limited liability company. But what if you don’t want any partners? What if you want to be the sole owner of your own LLC?

You can do that with a single owner LLC (sometimes known as a single member LLC).

But you have to be careful.

Before we discuss how to properly set up and use a single owner LLC we must acknowledge a nationwide trend. Courts are starting to deny sole owner LLCs the same protection as multiple member LLCs. The reason has to do with the charging order.

The charging order is a court order providing a judgment creditor (someone who has already won in court and is now trying to collect) a lien on distributions. A chart helps to illustrate:

Illustration showing typical multi-member LLC structure

John was in a car wreck. Moe does not have a claim against XYZ, LLC itself. The wreck had nothing to do with the duplex. Instead, Moe wants to collect against John’s assets, which is a 50% interest in XYZ, LLC. Courts have said it is not fair to Mary, the other 50% owner of XYZ, to let Moe come crashing into the LLC as a new partner. Instead, the courts give Moe a charging order, meaning that if any distributions (think profits) flow from XYZ, LLC to John then Moe is charged with receiving them.

Moe is not a partner, can’t make decisions or demands, and has to wait until John gets paid. If John never gets paid, neither does Moe. The charging order not only protects Mary but is a useful deterrent to frivolous litigation brought against John. Attorneys don’t like to wait around to get paid.

But what if there is only a single owner?

Illustration that shows a single member LLC structure

In this illustration there is no Mary to protect. It’s just John. Is it fair to Moe to only offer the charging order remedy? Or should other remedies be allowed?

How the Court Has Ruled Against LLCs With One Member

In June of 2010, the Florida Supreme Court decided the Olmstead vs. FTC case on these grounds. In a single owner LLC there are no other members to protect. The court allowed the FTC to seize Mr. Olmstead’s membership interests in order to collect. Other states have followed the trend.

Interestingly, even two of the strongest LLC states have denied charging order protection to single owner LLCs in limited circumstances.

In September of 2014, the US District Court in Nevada decided the bankruptcy case of In re: Cleveland.

The court held that the charging order did not protect a single member LLC owner in bankruptcy. Instead, the bankruptcy trustee could step into the shoes of the single owner and manage the LLC. This is not surprising since bankruptcy trustees have unique and far reaching powers, which are routinely upheld by the courts. (But know that, incredibly enough, a bankruptcy trustee can’t get control of the shares of a Nevada corporation. This is a special planning opportunity available to Nevada residents – or those who may become Nevada residents.)

In November of 2014, the Wyoming Supreme Court rendered a surprising verdict in the Greenhunter case.

The court held that the veil of a single owner LLC could be pierced. The issue centered on a Texas company’s use of a Wyoming LLC it solely owned. The LLC was undercapitalized (meaning not enough money was put into it) and it incurred all sorts of obligations. It wasn’t fair for the Texas company for the single owner to hide behind the LLC. The fact that a single owner LLC was involved was a material issue. The court pierced through the LLC and held the Texas company liable for the LLC’s debts.

Even though these are fairly narrow cases, both Nevada and Wyoming have held against single member LLCs. Again, this is the trend.

Luckily there are some things you can do to protect your assets as a single member LLC…

Strategies for Protecting Your Assets

One strategy is to set up a multi-member LLC structured in a way that gives the intended single member all of the decision making power. For example, parents can have adult children over 18 become member(s) or for those under 18 you can use a Uniform Gift to Minors Act designation. You may want to use an irrevocable spendthrift trust for children or others. A local estate planning attorney can help you set these up correctly.

But what is the smallest percentage you have to give up for the second member? Could you give up just 1/100th of 1 percent? Most practitioners feel that the percentage should not be inordinately low and that 5% is a suitable second member holding. So the ideal structure would be that John owns 95% of the LLC and the other 5% is owned by a child (or other family member) and/or an irrevocable trust.

Accordingly, in a state that doesn’t protect single owner LLCs, you have an excellent argument for charging order protection. There is a legitimate second member to protect. To further that legitimacy it is useful to have the second member participate in the affairs of the LLC. Attending meetings and making suggestions recorded into the meeting minutes is a good way to show such involvement.

But what if you don’t want to bring in a second member?

There are plenty of good reasons to set up a sole owner LLC. Other owners can bring a loss of privacy and protection. And if you paid 100% for the whole asset, why should you bring in another member anyway? Or, what if you don’t have any children or other family members that you want to bring in?

If a single member LLC is truly the best fit for you, there are three key factors to know and deal with.

1. The Corporate Veil

Many states’ LLC laws do not require annual meetings or written documents. Some see this as a benefit but it is actually a curse.

If you don’t follow the corporate formalities (which now apply to LLCs) a creditor can pierce the veil of protection and reach your personal assts. With a single owner LLC this is especially problematic. Because you are in complete management control it may appear that you aren’t respecting the entity’s separate existence or that you are comingling the LLC’s assets with your own personal assets. Without a clear distinction of the LLC’s separate identity, a creditor could successfully hold you personally responsible for the debts of the LLC (as they did in Wyoming’s Greenhunter case above.) Maintaining proper financial books and records and keeping LLC minutes can help demonstrate a definitive and separate identity for your single owner LLC. You must work with a company which appreciates the importance of this for single owner LLCs.

2. Different State Laws

LLC laws vary from state to state. Some states offer single owner LLCs very little protection. The states of California, Georgia, Florida, Utah, New York, Oregon, Colorado and Kansas, among others, deny the charging order protection to single owner LLCs.

Other states offer single owner LLCs a very high level of protection in traditional circumstances. So we have to pick our state of formation very carefully. In order to deal with this trend against protection, we use the states that do protect single member LLCs.

Wyoming, Nevada, Delaware, South Dakota and Alaska (collectively “the strong states”), have amended their LLC laws to state that the charging order in standard collection matters is the exclusive remedy for judgment creditors – even against single owner LLCs.

So how do we use these state laws to our advantage? Let’s consider an example:

A chart showing a properly structured single member LLC

In this example, John owns a fourplex in Georgia and a duplex in Utah. Each property is held in an in-state LLC (as required to operate in the state). The Georgia and Utah LLCs are in turn held by one Wyoming LLC. (This structure works in every state except California, which requires extra planning. Be sure to take advantage of our free 15-minute consultation if you are operating or residing in California).

I break down potential lawsuits into two different types of attacks: Attack #1, the inside attack and Attack #2, the outside attack.

In Attack #1, the inside attack, a tenant sues over a problem at the fourplex owned by GEORGIA, LLC. They have a claim against the equity inside that LLC. Whether GEORGIA, LLC is a single owner or multi-owner LLC doesn’t matter. The tenant’s claim is against GEORGIA, LLC itself. Importantly, the tenant can’t get at the assets inside UTAH, LLC or WYOMING, LLC. They are shielded since the tenants only claim is against GEORGIA, LLC.

The benefit of this structure comes in Attack #2, the outside attack. If John gets in a car wreck, it has nothing to do with GEORGIA, LLC or UTAH, LLC. But, the car wreck victim would like to get at those properties to collect on the judgment. If John held GEORGIA, LLC and UTAH, LLC directly in his name, the judgment creditor could force a sale of the fourplex and duplex since neither state protects single owner LLCs.

However, since John is the sole owner of WYOMING, LLC he is protected by Wyoming’s strong laws. The attacker can only get at WYOMING, LLC and gets a charging order, which means they have to wait until John gets a distribution and therefore could possibly never get paid. If John doesn’t take any distributions, there’s no way for the attacker (or his attorney) to collect. A strong state LLC offers a real deterrent to litigation, even for single owner LLCs.

3. Operating Agreement

Like bylaws for a corporation, the Operating Agreement is the road map for the LLC. While some states don’t require them, they are an absolute must for proper governance and protection. A single owner LLC operating agreement is very different than a multi-member operating agreement. 

For example, if a single owner transfers their interest in the LLC, inadvertent dissolution of the entire LLC can occur. This is not good. Or, again, what if the sole owner passes? Who takes over? Our Single Member Operating Agreement provides for a Successor Manager (a person you pick ahead of time) to step in.

The best way to deal with these issues, as well as others, is to have a specially drafted operating agreement to properly govern your Single Member LLC. Corporate Direct provides such a tailored document for our clients. When it comes to business and investments, you must do it the right way.